A Recent Hedge Fund Implosion Offers Lessons For Everyday Investors

Imagine if your investment manager not only lost all your money, but on top of that, you owed additional money. That’s the brutal reality facing one group of investors.

Hedge fund OptionSellers.com was recently forced into liquidation after making ill-timed energy market bets involving options. Per the Wall Street Journal, some client accounts ended up in a deficit, meaning they still owed the clearing firm after their principal disintegrated.

Here’s how the fund's manager, James Cordier, described his strategy in a book titled, The Complete Guide to Options Selling:

While writing naked options may sound outrageously aggressive and even frightening to some, if it is done correctly, one should be able to sleep very well at night. The downside, of course, is that the market potentially can exceed your risk parameter."

Selling naked options can be a seductive strategy because it often works in the early going. Option sellers can go on long, lucrative winning streaks, steadily collecting premiums.

However, trouble can and did erupt for OptionSellers.com when natural gas and oil volatility surged earlier this month.

After the fund imploded, Mr. Cordier took the unusual step of posting a 10-minute apology videoon YouTube. He sits at a desk, weeping at times. It’s hard to watch.

There's more to glean from this story though, beyond the potential perils of option strategies.

Mounting evidence suggests we are in the twilight phase of this investment cycle. Understanding three specific dimensions of went wrong for OptionSellers.com can help traditional investors better manage late-cycle risk in their portfolios.

A dirty little secret about hedge funds is not all of them hedge. Some do the opposite, using leverage to amplify results.

Volatility can go on hiatus for long periods. Like the tranquil atmosphere investors enjoyed last year. But when volatility returns, it often clusters. Meaning: volatility begets more volatility.

Traditional investors can protect their portfolio by reducing beta exposure (i.e. sensitivity to market volatility). That's precisely what many investors are doing lately, rotating out of stocks like the FAANGs and into more defensive securities. That has the S&P 500 Low Volatility Index outperforming the broader S&P 500 by a 6.5% margin quarter-to-date.

Leverage

Leverage is why OptionSellers.com investors owed more than they originally invested.

A lawyer familiar with the situation told Bloomberg, "When there weren’t enough assets in some of the accounts of a certain type to cover short naked calls, FCStone borrowed on margin against their clients’ accounts to cover, which caused them to not only lose 100 percent of their account values, but now they also owe FCStone for the loans."

Investor margin balances are just off a record-high level.

Corporations are also fully levered. Business debt as a percentage of GDP is as high as it's ever been.

High amounts of leverage in the system become dangerous once volatility picks up in a sustained fashion. The two feed off one another, eventually leading to forced liquidations. That's what turns ordinary selloffs into full-scale panics, like we started to see glimpses of in October.

One way to safeguard an equity portfolio is favoring firms with strong balance sheets. Bloomberg data shows low-debt firms (i.e. the top quintile) in the U.S. have outperformed high-debt firms (i.e. bottom quintile) by 11.7% over the last twelve months. That trend will probably continue.

Commodities

Not only was OptionSellers.com pursuing a risky strategy (i.e. selling naked options), amid a climate of rising volatility, but the strategy was also reliant on an especially volatile asset class.

Commodities like natural gas and oil can be a very wild ride. WTI crude oil is down over 30% from where it traded in early October. Meanwhile, natural gas futures are up over 50%. Huge moves!

Everyday investors should tread carefully in commodities and commodity-sensitive securities.

One reason this space is so volatile is commodities lack a clearly defined value compass. There's no cash flow or income stream to calculate a yield from.

When a bond or dividend paying stock declines in price, it has a yield that rises. The higher the yield rises, the more income investors will flock toward it. That demand magnet helps limit price declines.

With commodities, the price is the price. This makes determining a fair value range trickier than normal, exacerbating the potential for extreme price moves.

***

In a late-cycle environment, it's unwise to pursue any strategy analogous to "picking up nickels in front of a steamroller."

Stick with simple, liquid, lower-risk strategies. Doing so will help avoid the really bad outcomes, which become progressively more common after a cycle peaks.

I am the founder and President of Silverlight Asset Management, which provides investment advisory services through CS Planning Corp. I’m also a columnist for RealClearMarkets. I have a Bachelor’s degree in Government from Georgetown University and hold the Chartered Financi...